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Tuesday, January 19, 1999

An Investment Opinion
by Warren Gump

A Bright Future for Coast Dental?

Stocks of small companies have certainly been out of favor for a while, with the Russell 2000 index being trounced by the Standard & Poor's 500 over the past few years. This leads me to believe there are some stocks with great growth prospects that are available at reasonable valuation levels. I'm going to try to highlight some of these that come across my desk that look like they might have some long-term growth potential. Today's company, Coast Dental Services (Nasdaq: CDEN), came to my attention via the Fool's turnarounds/value investing message board.

The following financial characteristics caught my eye. Coast, which has a tiny market capitalization of $68 million, trades at only 13x First Call's consensus earnings estimates for 1998 (and 9x estimates for 1999). The projected long-term growth is about 35% (of course, this is more a guess than a forecast). In addition to having solid earnings growth, the company has a strong balance sheet to support its growth initiatives. As of the end of September, Coast had about $6 million in total debt and an offsetting cash balance of over $33 million.

Before discussing what the company does, another important financial attribute of this company is that it has positive cash flow from operations. During the first nine months of 1998, Coast netted $2.5 million from operations. This number is down from $3.2 million the prior year as management fees receivable and inventory jumped because of the company's rapid growth. While operating cash flow is not sufficient to fund the company's growth (a total of almost $20 million was spent on capital expenditures and acquisitions during this same time period), it is nice to see positive cash flow produced by operations.

Coast manages dental practices in the Southeast. Since opening its first center in May 1992, the company has acquired 57 facilities in Florida, Georgia, and Tennessee to supplement its opening of 41 additional internally developed centers. Most of these offices are clustered in metropolitan areas such as St. Petersburg, Orlando, Daytona, Atlanta, and Nashville. As of September 30, 1998, the company had 102 affiliated dentists serving over 600,000 patients.

Coast's strategy is to provide management services to dental offices so that the dentists can spend more time working with patients. Beyond just freeing up time for the dentist, the company should be able to operate the office more efficiently by using standardized procedures. In addition, the company can develop a critical mass of offices in its target markets.

By having a large number of centers in one market, Coast can more efficiently utilize its advertising budget. More expensive and comprehensive forms of advertising might be too expensive for an individual dentist, but they might be cost effective for an affiliation of 14 dentists working in the same metropolitan area. Having a large number of offices is also beneficial when courting managed care partners, who want to offer their customers a large number of providers.

As with other dental practice management (DPM) and physician practice management (PPM) firms, Coast Dental had a rough ride in 1998, falling from a high of over $30 a share to its current price around $9 per share. Investors were fearful of these stocks all year long due to the well-publicized problems at PPMs such as MedPartners (NYSE: MDM) and PhyCor (NYSE: PHYC) related to slow results from acquired clinics and poorly estimated medical reserves.

The bomb really dropped for Coastal last June, when the company announced that it would not meet earnings expectations for last year's second quarter. The company expanded more quickly than anticipated "due to market opportunities" and more of the new units were developed internally, lowering their initial contribution to operating income.

Recognizing that any earnings warning is going to increase skepticism among investors, let's think through this specific warning a little more thoroughly. Do you want to invest your money with a management team that pursues acquisitions for growth's sake regardless of the economics? Or would you prefer to have one that evaluates opportunities, recognizes that the price demanded for acquisitions is too high, and changes course by internally developing facilities that are more cost effective? I would go with the latter.

Several competitors are trying to make a dent into this nascent market. Two of the more promising are Dental Care Alliance (Nasdaq: DENT) and Castle Dental Centers (Nasdaq: CASL). I prefer Coast over these two because it has a better balance sheet than Castle and a more attractive P/E-to-Growth (PEG) ratio than Dental Care Alliance.

I am not knowledgeable enough about the dental field to know whether dental practice managers are the wave of the future or not. If it is, Coast appears to have the right financial ingredients to be a successful competitor. Perhaps this article will spark readers familiar with this business to share their thoughts and expectations on our Coast message board.

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